Undercover operation shows broker advice missteps

Wed Apr 4, 2012 3:56pm EDT

A picture illustration shows a 100 Dollar banknote laying on one Dollar banknotes, taken in Warsaw, January 13, 2011. REUTERS/Kacper Pempel

A picture illustration shows a 100 Dollar banknote laying on one Dollar banknotes, taken in Warsaw, January 13, 2011.

Credit: Reuters/Kacper Pempel

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(Reuters) - People make a lot of dumb investing mistakes. And they should not expect financial advisers to correct them.

That is one finding from two studies that used actors posing as middle- and upper-middle-class Americans looking for financial advice. Their experiences should set off alarm bells for investors and the compliance officers who monitor adviser behavior.

The undercover visits - nearly 800 in total made in 2008 and again in 2011 - are detailed in a study recently published by the National Bureau of Economic Research and another to be released by June. Researchers wanted to know if advisers tried to correct investors if they were going down a high-risk road, such as concentrating their money in a hot sector or their employer's stock.

The result? The study found advisers often reinforced harmful investor behavior when it was in their best interest to do so.

For instance, actors who pretended that their investments were concentrated in the latest hot industry should have been told to diversify their holdings. Instead many advisers who work on commission - often called brokers - supported the trend-chasing strategy. One reason: brokers can turn over a concentrated portfolio frequently as one hot idea fades and another catches fire, the study said.

Most of the advisers studied were paid commissions generated from products they sold.

When fees were mentioned, advisers downplayed them, the study revealed. For example, an adviser might say "this fund has a 2 percent fee but that is not much above industry average." That is at least double what an investor should be paying, even for an actively managed fund, said Jeff Tjornehoj, a senior research analyst with Lipper who was not involved in the study.

Actors who said they were invested in low-fee, diversified index funds were frequently told to move into more expensive actively managed funds that would earn the broker a larger commission.

Meanwhile, advisers were significantly more likely to steer someone toward low-cost index funds only when actors said they had all of their money in cash.

While actively managed funds could be a sound move for some clients, said Sophie Schmitt, a senior analyst with the research firm Aite Group, the study authors operated from the premise that the returns on actively managed funds are almost always worse for clients after taking the higher fees into account. The study did not name the firms the actors visited.

Brokers also made other, more basic missteps. Actors were not regularly asked questions about their income, occupation and marital status - all factors that impact how much risk a client should take.

There is no suggestion that the advisers the actors visited did anything illegal. But the results revealed a mismatch between the financial advice clients need and what they end up with - financial products that may not be the best fit but generate a healthy commission for the adviser, said Antoinette Schoar, a co-author of the study and professor of finance at MIT's Sloan School of Management.

The first study, originally released as a working paper in 2010, was based on 284 client meetings in 2008 with retail financial advisers who worked in banks, independent brokerages and investment advisory firms. The results of 500 additional undercover meetings conducted in 2011 will be released by June. Schoar said the results of those visits closely mirror the 2008 results.

The actors visited advisers in the Boston and New York areas pretending to have savings of either $45,000 to $55,000 or of $95,000 to $105,000. The actors were given scripts and were trained on financial literacy - then tested on their knowledge - before meeting with advisers. Actors took notes on information given to them by advisers and then had 24 hours after the meeting to complete the study's online questionnaire about the visit.

COMPLIANCE NEEDS

In contrast to fee-based advisers, who charge clients based on the amount of money they manage and are required to put the clients' interest first, brokers paid on commission only have to recommend investments that are suitable for clients, regardless of whether one choice costs much more or leads to a higher commission for the broker.

Either way, compliance officers are charged with training advisers on the steps that need to be taken in meetings with all new clients - and they must monitor for missteps.

When advisers working under the suitability standard recommend a product, they are required by the Financial Industry Regulatory Authority, the industry's private regulator, to attempt to gather and analyze information on a client's investment objectives, other holdings, financial situation and tax status.

Compliance officers should routinely sample advisers' paperwork to look for answers to basic demographic questions, said Blaine Aikin, chief executive of fi360, which provides training, analytical tools and support for advisers. They should also check that each client has an investment policy statement with their goals, limitations and risk tolerance, Aikin said.

While study co-author Schoar faults the industry for not aligning the interests of clients and advisers, she said clients also bear blame for the bad direction they receive from brokers.

They are often reluctant to pay advisers just for advice and instead want something to show for their money, like a product. And many clients do not take the time to figure out if an adviser is steering them in the right direction or simply trying to earn a bigger commission.

Case in point: 70 percent of the actors in the study said they would bring their own money back to the adviser they met.

(Reporting By Jennifer Hoyt Cummings in New York; Editing by Jennifer Merritt and Matthew Lewis)

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